Credit Default Swaps, AIG, and the Fed – Will $123 Billion Be Enough?

Update on the Fed’s $123 billion in emergency lending to AIG.

For those intrigued by my credit default swap post, there is a good article in yesterday’s New York Times. The article asks, “where are the funds being lent to AIG by the Fed going within the company”

The American International Group is rapidly running through $123 billion in emergency lending provided by the Federal Reserve, raising questions about how a company claiming to be solvent in September could have developed such a big hole by October. Some analysts say at least part of the shortfall must have been there all along, hidden by irregular accounting.

The article goes on to describe that accounting for its derivatives trades, largely the selling of credit default swap protection, had been severely lacking oversight. As more attention was drawn to the activities of AIG’s Financial Products group, an alarming picture began to emerge.

From the Times:

An accountant brought in by the company because of an earlier scandal was pushed to the sidelines on this issue, and the company’s outside auditor, PricewaterhouseCoopers, warned of a material weakness months before the government bailout.The internal auditor resigned and is now in seclusion, according to a former colleague.

In November of 2007, AIG said their best estimate of losses on their credit default swap portfolio stood at $1.6 Billion. After pressure from their auditor, PricewaterhouseCoopers, they issued a new estimate in February of 2008; at that time, they estimated losses of $5.9 billion. From there, as the Times reports, loss estimates continued to grow:

Through spring and summer, the company said it was still gathering information about the swaps and tucked references of widening losses into the footnotes of its financial statements: $11.4 billion at the end of 2007, $20.6 billion at the end of March, $26 billion at the end of June.

As the subprime mortgage market deteriorated, the CDS losses mounted at AIG. When AIG’s credit rating was cut by the major ratings agencies, it triggered covenants in the swap contracts that allowed its counterparties in the CDS trades to immediately require AIG to post more collateral. The New York Times reports that, “By midyear, the insurer had been forced to post collateral of $16.5 billion on the swaps.” These sudden collateral calls on billions of swap contracts pushed AIG into a severe liquidity crunch and eventually into the arms of the Fed.

The Fed extended AIG $123 billion in emergency lending through two separate loans. In turn, the Fed took a majority stake in AIG through equity warrants issued by the company. The Fed recently released an update showing AIG has drawn down roughly $90 Billion on the two loans it has extended to the company. Of the $90 Billion AIG has drawn on the credit lines:

  • $18 billion has been used to shore up its securities lending facility;
  • $13 billion has been used to shore up investments accounts called “guaranteed investment contracts;”
  • The remaining $59 billion – according to the Times, AIG has not provided a breakdown beyond stating that, “it has been used for day-to-day operations. “

Of the $59 billion, it is assumed that much of it is being posted as collateral for its credit default swap trades. AIG has a $447 billion portfolio of credit default swaps; just how much of that portfolio AIG will need to pay up on remains to be seen. The risk of additional losses remains as long as housing prices and the credit condition of major corporations continue to deteriorate.

Will the $123 billion from the Fed be enough?

Maybe or maybe not is the answer AIG’s new CEO, Edward Liddy, gave in an interview on the News Hour with Jim Lehrer. As reported by Bloomberg, Liddy said,

“To the extent they continue to go down and we have to keep posting collateral, as it’s called in the vernacular of the industry, it’s possible it may not be enough,”

Liddy also said,

he thinks AIG “should be OK,” that he still hopes to stay within the $122.8 billion ceiling…

So with the U.S. Fed now AIG’s largest shareholder and creditor, what do we know about the company’s financial condition? According to the Times:

A.I.G. has declined to provide a detailed account of how it has used the Fed’s money. The company said it could not provide more information ahead of its quarterly report, expected next week, the first under new management.

In fairness to AIG, they are prohibited from selectively releasing material information… Looks like we will have to wait until next week.


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Related Reading From the SpeciousRiches Bookshelf:

Fooling Some of the People All of the Time; by David Einhorn


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